Monetary Policy, Inflation Target and the Great Moderation: An Empirical Investigation

This paper estimates a New Keynesian model with trend inflation and contrasts Taylor
rules featuring fixed versus time-varying inflation target while allowing for passive
monetary policy. The estimation is conducted over the Great Inflation and the Great
Moderation periods. Time-varying inflation target empirically fits better and active
monetary policy prevails in both periods, thereby ruling out sunspots as an explanation
of the Great Inflation episode. Counterfactual simulations suggest that the decline in
inflation volatility since the mid-1980s is mainly driven by monetary policy, while the
reduction in output growth variability is explained by the reduced volatility of technology
shocks.